There are thousands of books on investing, a point highlighted in a back cover quote by Peter L. Bernstein: “Books on personal investing are a dime a dozen. But if we add them up, all those dimes come to plenty of money.” It was Bernstein’s contention that Christopher L. Jones’ The Intelligent Portfolio[3] was a cut above the rest with its “strong foundation in theory, the depth of its insights, the power of its message, the clarity of its exposition, and the value of its examples.” That’s quite a laundry list, but does The Intelligent Portfolio deliver? That depends.

About The Author

First, a little about the author. Christopher L. Jones is the Chief Investment Officer and Executive VP of Investment Management for Financial Engines[4], a personalized investment advice and management service. One of the bonuses of the book is that you get a free yearly access pass to Financial Engines through a code written on a card in the book.

At this point you might think – hmmm, this sounds a little fishy. He’s the CIO and EVP at a generic sounding financial company, what’s the big deal? Hold on, Financial Engines, Inc. provides advisory services to 109 of the Fortune 500 companies and its services touch the assets of 6.8 million employees. As of the end of 2007, they were managing over $16 billion in defined contribution assets on a fee basis. They’re a pretty big deal.

About The Book

It’s not every day you read a book written by an EVP of Investment Management of a financial advisory and management company that tells you question the advice of experts and to approach everything, especially investing, with a very healthy dose of skepticism. From the preface: “… many of the most important ideas from financial economics, promoted by popular media and advertised by financial services firms, are distorted or misused in order to sell more products and services.”

So, given that knowledge, what do we need to focus on, according to Mr. Jones? He lists the following ten basic concepts:

Recognize the linkage between risk and reward

Avoid being deceived by history

Leverage the wisdom of the market

Select an appropriate risk level

Avoid the perils of stock picking

Don’t spend too much on investment fees

Diversify intelligently

Select funds using relevant forward-looking criteria

Understand how to realistically fund financial goals

Invest tax-efficiently

At the 30,000 foot level, all those concepts seem pretty straight forward. “Avoid being deceived by history” likely refers to how you shouldn’t base investment decisions on historical returns. “Don’t spend too much on investment fees” probably talks about how you need to check expense and sales ratios on funds and manage advisor fees and such.

The chapter I’ll highlight below was the one about avoiding stock picking since I, like many others, can’t seem to avoid the perils of stock picking (I own shares of Yahoo FTW!).

Avoid picking individual stocks

The crux of the chapter is that for the last few decades, investing the stock market usually meant investing in individual stocks. Mutual funds, index funds (which are mutual funds), and ETFs are all fairly recent investment vehicles. The problem with investing in individual stocks is that it’s risky and investors underestimate the risk and return involved, thus making a disastrous combination. Jones contends that most investors think that the risk of an individual stock is comparable to a mutual fund, despite it being significantly riskier. Financial Engines calculated that, as of Jan 07, the risk level, or volatility level, of the Vanguard 5000 Index fund was 1.5 (a market portfolio has a risk level of 1.0), can you guess the risk level for Dell? How about Pfizer? Or Tivo? (Dell was 3.7, Pfizer was 2.6, Tivo was 5.5) This is expected, I think it’s how much they differ that surprises people.

The three risk types that affect individual stocks are market risk, company risk, and industry risk. With a mutual fund of many companies in numerous industries, company specific risk and industry risk are mitigated and often hedged by other holdings. Every domestic holding faces market risk, but the fact is that the company risk and industry risk effects on one stock are far more significant than on a basket of stocks in diversified markets.

Okay no big deal, we all know one stock is riskier than a fund of the five hundred stocks of the S&P 500. I think my stock pick is a winner and I’m comfortable putting that bet on the table. Jones then did a study where they randomly picked a single stock from each of the S&P 500, S&P 400, and S&P 600 (they represent large cap, mid cap and small cap US stocks), hold it for month and then buy something else, and then see if the stock would outperform its parent index over a 10 year period between 1995 and 2005.

They ran 100,000 hypothetical investors and the results were that the single stock monthly flipper lost. In fact, in the case of the S&P 600 small cap, the median cumulative return was 3.4% vs. the index’s 13.70% return, over 10% different. With the S&P500, 62.80% of the hypothetical investors lost out to the index itself. With the S&P400, 74.10% were losers and with the S&P600, $74.60% were losers. Do you think you’ll be in the top 30% each and every year?

Conclusion

I learned quite a bit about constructing a good portfolio and what the important factors are when selecting various investments. It was fun learning what alpha meant (manager alpha refers to how much a fund manager beats its underlying investment style) and get a few more factors to look at when comparing mutual funds. On the other, it did make a strong, indirect case for sticking to index funds because it mentioned the importance of managing fees very often and how it’s important not to let them eat into your returns.

I may give the Financial Engines a look over the next few months, as it was referenced very frequently in the book (you get a free annual membership with the purchase of the book, so it’s not like it’s a sales pitch or anything), and hopefully they have some more of the same type of interesting simulations and statistic analysis the book carried.